Using a Fixed Annuity for Fixed Income

Last year was a difficult year for bond investors. Most major bond indices ended lower. Looking ahead, it’s not easy to find value opportunities in today’s bond market. Valuations are soaring and persistently low bond yields can cause investors to chase yield – in search of income in risky places. This may not end well.

So, what to do with your bond portfolio? Ditch bonds altogether and go cash? Cash is not very productive and interest is taxable. CDs? Not a fan. Interest on CDs is taxable, and you lock in a low interest rate today, just when yields could rise this year. There are other solutions, such as building an actively managed diversified bond position, buying bonds at different maturities to get more yield, or building a CD ladder by buying different maturities. (For more ideas, register here to join our 2022 Asset Allocation webinar – Where do we go from here? Where to invest?, February 25.) But one solution that has some interesting advantages is the fixed annuity. Here is what I mean:

What is a fixed annuity?

A fixed annuity is a contract issued by an insurance company that guarantees* a fixed rate of interest on your savings for a specified period. There are fixed deferred and immediate annuities. A deferred annuity focuses on the accumulation of savings, less on income. An immediate annuity is for immediate income. I will focus on deferred fixed annuities.

When you buy a deferred fixed annuity, the insurance company pays an interest rate on the premiums invested in the contract, less any applicable fees. The interest rate is determined by the insurance company and is specified in the annuity contract. While the insurance company guarantees* that it will pay a minimum interest rate for the duration of the annuity contract, a company may also pay an “excess” or bonus interest rate, which is guaranteed for a longer period. short, like a year. Here are the current rates, net of fees, for a 5-year fixed annuity with a major insurance company:

Figure 1: Rates are indicative only; actual experience may differ.

The Year 1 rate includes the initial rate or “base rate” plus a premium. In years 2 through 5, the insurance company guarantees that the base rate will increase by 0.10% per year. Rates can be reset each year after the fifth year. Interest rates are higher for contributions over $100,000. It’s usual.

Advantages of the fixed annuity

Main protection

The insurance company guarantees your capital against losses. Compare that to a traditional bond, where prices can fall if interest rates rise. Keep in mind that the warranty is only as good as the company offering it, so you should choose a highly rated carrier.

Tax deferral

Interest accrues tax-free each year you wait to withdraw. Taxes are delayed until you withdraw money, then income is taxed as ordinary income (assuming you purchased into a non-retirement ordinary account; qualified Roth IRA distributions are exempt from tax).

In this low interest rate environment, tax deferral is a key benefit of using fixed annuities. Interest earned on treasury bills and CDs is taxable at ordinary income rates. Interest on municipal bonds is tax exempt at the federal level, but there may be state taxes and the interest could trigger an AMT preference element. Ideally, you want to wait to withdraw from a fixed annuity until you are in a lower tax bracket, such as retirement, or at least until age 59½.

Higher interest rates

Fixed annuities generally pay a higher interest rate than CDs. Although this may not be a fair comparison, since CDs are guaranteed against losses up to $250,000 by the FDIC, better coverage than an insurance company (some drives may not be OK). Either way, interest on CDs is taxable each year, an important distinction.

Disadvantages or what to pay attention to

No investment is perfect. Here are a few things to keep in mind:

  • There is a penalty for withdrawing all of your money from a fixed annuity in the early years, usually years 1-5. However, most carriers allow you to withdraw 10% of the contract (interest and principal) annually without penalty.
  • Interest is taxable when withdrawn.
  • If you are under 59.5, there is a 10% early withdrawal penalty.

For these reasons, you want to make sure you have extra cash available in case of an emergency. For my retired clients, interest is usually paid monthly from the fixed annuity – assuming it falls under the 10% free withdrawal – to provide income.

You also want to choose a highly rated insurance company. Some fixed annuities pay high rates, but they come from a lower quality company. High ratings are important, since the primary coverage is backed by the claims-paying ability of the business. Check the insurer’s ratings with agencies such as AM Best, Standard & Poor’s and Moody’s.

Final Thoughts

If you want principal protection, tax deferral and a competitive interest rate, a fixed annuity is worth considering for a portion of your fixed income. I say “part” because I believe in creating a diversified portfolio of fixed income securities – a mix of taxable and non-taxable bonds, inflation-protected treasury bonds, active management styles and passive.

There is no one size fits all, just different strokes for different people.

For more information on how a fixed annuity works, please email me at [email protected].

* All coverages are based on the claims-paying ability of the issuing insurance company.

Investment advice and financial planning services are offered by Summit Financial LLC, an SEC-registered investment adviser, 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600 Fax. 973-285-3666. This document is intended for your information and advice and is not intended to be used as legal or tax advice. Clients should make all decisions regarding the tax and legal implications of their investments and plans after consulting their independent tax or legal advisers. Individual investors’ portfolios should be constructed based on the individual’s financial resources, investment objectives, risk tolerance, investment time horizon, tax situation and other relevant factors. Past performance is not indicative of future results. The views and opinions expressed in this article are solely those of the author and should not be attributed to Summit Financial LLC. Links to third party websites are provided for your convenience and informational purposes only. Summit is not responsible for information contained on third party websites. Summit’s financial planning design team has admitted attorneys and/or CPAs, who act exclusively in a non-representative capacity with respect to Summit clients. Neither they nor Summit provide tax or legal advice to clients. Any tax statements contained herein were not designed or written to be used, and may not be used, for the purpose of avoiding US federal, state, or local taxes.

CFP®, Summit Financial, LLC

Michael Aloi is a CERTIFIED FINANCIAL PLANNER™ Practitioner and Certified Wealth Management Advisor℠ with Summit Financial, LLC. With 21 years of experience, Michael specializes in working with executives, professionals and retirees. Since joining Summit Financial, LLC, Michael has implemented a process that emphasizes integrating the various facets of financial planning. Supported by an in-house team of estate and tax specialists, Michael provides clients with coordinated solutions to disparate issues.

Investment advice and financial planning services are offered by Summit Financial LLC, an SEC-registered investment adviser, 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600 Fax. 973-285-3666. This document is intended for your information and advice and is not intended to be used as legal or tax advice. Clients should make all decisions regarding the tax and legal implications of their investments and plans after consulting their independent tax or legal advisers. Individual investors’ portfolios should be constructed based on the individual’s financial resources, investment objectives, risk tolerance, investment time horizon, tax situation and other relevant factors. Past performance is not indicative of future results. The views and opinions expressed in this article are solely those of the author and should not be attributed to Summit Financial LLC. Links to third party websites are provided for your convenience and informational purposes only. Summit is not responsible for information contained on third party websites. Summit’s financial planning design team has admitted attorneys and/or CPAs, who act exclusively in a non-representative capacity with respect to Summit clients. Neither they nor Summit provide tax or legal advice to clients. All tax declarations contained in this document have been not intended or written to be used, and may not be used, for the purpose of avoiding US federal, state or local taxes.

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